The decision by the SEC’s administrative law judge (ALJ) to ban China’s Big Four accounting firms for six months creates serious uncertainty for U.S. multina-tional corporations (MNCs) with significant operations in China. If the ALJ’s decision stands, the ban would mean that the China member firms of the Big Four would be unable to participate in the audits of U.S. listed MNCs, jeopard-izing the ability of these MNCs to file the financial statements required to remain listed in the U.S. Audit committees need to have a plan B.
The China Big Four firms have appealed the ALJ decision to the full SEC Com-mission. I understand that the Commissioners have seven months to make a decision, although they can extend that period. In a worst-case scenario, they could act tomorrow, but I think it is unrealistic to think that they would do so. A realistic worst case is that they act in September as the seven months ends. While I expect the Commissioners to affirm the ban, I am hopeful that they will restrict it to foreign private issuers, exempting work on MNCs. The SEC asked the ALJ to limit the ban this way, but the ALJ did not believe he had the author-ity under the law to do so. I hope the Commissioners decide they have that authority. If the Commissioners limit the ban to foreign private issuers, there should be no problem for most MNCs. The U.S. Chamber of Commerce ought to be screaming at the SEC to do this. Foreign private issuers (U.S. listed Chinese companies), however, are screwed but their plan B is not the subject of this post.
I came across this one-post blog called Chinese Stock Fraud. The most interest-ing information is a list of Chinese stock frauds in Singapore, Hong Kong, and the U.S. and Canada.
The author lists 121 companies; 54 in the US and Canada, 44 in Hong Kong, and 23 in Singapore. It is the best list I have seen of Hong Kong and Singapore frauds. A number of alleged but unproven frauds are not included, even though some of these remain suspended from trading (i.e. AMBO, FU). The author lists no alleged frauds on Chinese exchanges.
One of the great challenges for academic researchers has been coming up with a comprehensive list of Chinese frauds.Zigan Wang of Columbia wrote a paper explaining the difficulty involved in just identifying U.S. listed Chinese firms. Because these companies are usually incorporated outside of China, a list of Chinese companies listed overseas must be derived from secondary inform-ation, like location of head office or percentage of assets in China.
I am encouraging a graduate student to take on a project to create a compre-hensive list of Chinese frauds. The first task is to define a fraud, and that may lead to several lists. Short seller attacks, auditor resignations, delistings, and class action lawsuits are all indicators of fraud but do not definitively establish that a company is a fraud. Such lists, however, may provide the basic data to determine what factors lead to fraud.
The SEC has paid great attention to the disclosures related to VIEs and investors today have considerably more data to evaluate the risks of these structures. Companies have been forced to disclose much more information. For example, New Oriental’s 2008 financial statements included 494 words discussing VIE arrangements. By 2012 this had grown to 3,024 words. There is so much data available that Fredrik Oqvist has created a database to make sense of it. The database is useful to scholars and investors who are studying the risks of VIEs.
It has been very difficult to evaluate VIE risks of companies listed in Hong Kong. Hong Kong listed companies follow IFRS, which has not required the same disclosures that the SEC requires for companies following U.S. GAAP. It is often difficult to figure out if a Hong Kong listed company even has a VIE structure. That is about to change.
Two years ago I posted about a pending change in IFRS that would require VIE disclosures. That change was effective on January 1, 2013, so we are about to see 2013 financial statements issued under the new rules. PwC has a great book on how the changes will work.
PCAOB Chairman James Doty presented his budget to the SEC Commissioners today. Doty said:
Gaining access to audits of Chinese registered firms has been particularly challenging. But I am grateful to the Secretaries of the Treasury and State for their inviting me, with your support, to participate in the Strategic & Economic Dialogue in each of the last three years.
These meetings proved instrumental to achieving some success. In 2013, we were able to reach an enforcement cooperation agreement with Chinese authorities.
Based on recent discussions, I am also optimistic that we will be able, during 2014, to sign a long-sought agreement to inspect the audit work of PCAOB-registered firms based in China.
In comments to reporters Doty indicated that China and the PCAOB are exchanging draft agreements. The Chinese are having a problem with the PCAOB conducting inspections on the ground in China. Doty indicated they are looking at alternatives including moving the papers and making people available outside of China. Since I am married to a Big Four audit partner, I suggest that the inspections take place in an American location with nonstop flights from China.